Federal Reserve and Monetary Policy

Describe three ways in which the Federal Reserve can change the money supply. Control Discount Rates One way of the Federal Reserve is to control the discount rates. Discount rate is “the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank's lending facility--the discount window” (Federal Reserve Board, 2007). As a result, increasing the discount rate would lessen the bank’s borrowing of money from the Federal Reserve and therefore decrease the money supply.

Consequently, decreasing the discount rate increases money supply due the increase in bank’s borrowing. Control of the Reserve Requirements Another way of the Federal Reserve is its regulatory control over the reserves of banks. “The reserve requirements are the amount of funds that a depository institution must hold in reserve against specified deposit liabilities” (Federal Reserve Board, 2007). By changing the proportion of total assets that banks must hold in reserve with the central bank, the Federal Reserve can control the amount of funds that are available for loan.

If there are more funds for loan, then this increases the money supply, if there are lesser funds for loan, this in turn decreases money supply. Conduct Open Market Operations The third way of the Federal Reserve is to conduct open market operations to increase or decrease money supply. To increase money supply, Federal Reserve can buy bonds in the open market. To decrease money supply, Federal Reserve can sell bonds in the open market. Figure 1. “Money Market & GDP Curves” (McConnell, 2005)

If the Federal Reserve is going to adjust all of these tools during an economy that is growing too quickly, what changes would they make? The Federal Reserve can manipulate the discount rate, reserve requirements and open market operations to reduce the growth of the economy. In order to control the quick economic growth, the Federal Reserve must sell bonds into the open market, increase the reserve ratio to decrease the available funds for loan, and/or increase the discount rate.

All of these reduce the money supply which in turn increases the interest rates when people borrow money from banks or other lending firms. The increase in interest rates deters investment and thus reduces investment spending. People would tend to store money because of its higher value. This higher value is somehow indicated by the higher interest rate. The overall result is reduction in investment spending. This reduction in investment spending would mean a reduction in the economic growth.